Falling Behind: Bank Data On The Role Of Income And Savings In Mortgage .

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October 2018Falling Behind: Bank Data on the Roleof Income and Savings in Mortgage DefaultBy Diana Farrell, Kanav Bhagat, and Chen ZhaoIntroductionFor many American households, buying a home represents one of their largest lifetime expenditures. And because most homeowners financetheir home purchase with a mortgage, buying a home is also one of their largest sources of debt. In our report Mortgage Modificationsafter the Great Recession: New Evidence and Implications for Policy, we measured the impact of mortgage payment and principal reductionon default and consumption. We found that a 10 percent mortgage payment reduction decreased default rates by 22 percent, whereas forborrowers who remained underwater, principal reduction had no effect on default or consumption. This finding implies that short termliquidity was a key factor driving mortgage default.Figure 1: For homeowners who defaulted, a substantialnegative income shock preceded their default.Using a sample of de-identified Chase customers whohad both a Chase mortgage and a Chase deposit account,we analyzed the relationships between negative incomeshocks, savings, and mortgage default.Findings For borrowers who defaulted on their mortgage,default closely followed a negative income shockregardless of their level of home equity. For borrowers who defaulted on their mortgage,default closely followed a negative income shockregardless of their income level or payment burden.In fact, we found that for homeowners who defaulted on theirmortgage, default was correlated with a drop in income. Thisis illustrated in Figure 1, which is reproduced from MortgageModifications after the Great Recession and shows the relationshipbetween income loss and default for a sample of de-identifiedChase mortgage customers who had a Chase deposit account anddefaulted on their mortgage.1, 2 Figure 1 shows the change in thepath of monthly income (where income is defined as all checkingaccount inflows) and mortgage payment made over the 12 monthsbefore and after default relative to a baseline period (12 monthsbefore default).3 Income dropped in the five months leading up todefault and, a few months after the initial drop in income, mortgagepayments also declined until borrowers defaulted.4, 5 Recovering from mortgage default was associatedwith recovering from a negative income shock;homeowners who experienced deeper and longerduration drops in income became increasinglydelinquent. Homeowners with larger financial buffers usedtheir savings to delay mortgage default following anegative income shock. Default rates for homeowners with small financialbuffers were higher regardless of income level orpayment burden. Therefore, building and maintaininga financial buffer may be a more effective tool tohelp borrowers avoid default than meeting total DTIstandards at origination.1

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultIn this follow-up research to our Mortgage Modifications after the Great Recession report, we further examined the relationship betweenincome shocks and mortgage default. We found that the relationship between negative income shocks and mortgage default illustratedin Figure 1 held for homeowners across all levels of home equity and regardless of income level or total debt-to-income ratio (DTI) atorigination. Deeper and longer duration negative income shocks were associated with increasing delinquency, whereas to the extenttheir income recovered quickly, homeowners promptly resumed making their mortgage payments. Homeowners with savings used theirfinancial buffer to delay mortgage default following a negative income shock. Finally, we examined the relationships between financialbuffers, income, payment burden, and default rates. Homeowners with larger financial buffers had lower default rates regardless of theirincome level or payment burden.Taken together, these findings suggest that providing borrowers with an incentive to build and maintain a post-purchase financialbuffer may be a more effective approach to default prevention than underwriting standards based on meeting ability-to-repay rulesat origination.2

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultFindingOneFor borrowers who defaulted on their mortgage, default closely followed anegative income shock regardless of their level of home equity.In Mortgage Modifications after the Great Recession, we separately examined above water and underwater households and found thatfor both groups, default followed shortly after a negative income shock. But was the relationship between income and mortgage defaultdifferent for borrowers with substantial negative equity? To answer this question, we divided our sample into more granular loan-to-value(LTV) bands. Specifically, we divided the above water households into those with an LTV below 80 percent and those with an LTV between80 and 100 percent. Similarly, we divided the underwater households into those with an LTV between 100 and 130 percent and those withan LTV above 130 percent in order to isolate borrowers with a large amount of negative equity.The results for each LTV group are illustrated in the four panels of Figure 2, each of which is analogous to Figure 1, showing the change in thepath of monthly income and mortgage payment made over the 12 months before and after default relative to a baseline month (12 monthsbefore default). Figure 2 only includes households for whom we observe LTV at default.6 In each panel of Figure 2, the pattern is similar to thepattern in Figure 1: income steadily dropped in the months leading up to default, regardless of the borrower’s home equity.The similarity in the relationship between income shock and default for various LTVs provides further evidence that underwater borrowers,including those who were deeply underwater, did not default only because they owed more on their mortgage than their house was worth.If some borrowers were defaulting simply because they were underwater, our data would show a smaller drop in inflows around default forborrowers with high amounts of negative equity, such as those with an LTV above 130 percent. Instead, the income drop experienced byborrowers with an LTV above 130 percent is similar in magnitude to the income drop experienced by lower LTV borrowers. Therefore, ourdata are inconsistent with this simple type of strategic default.7Figure 2: Default followed a negative income shock for borrowers across the LTV distribution, providing suggestiveevidence against a simple model of strategic default where deeply underwater borrowers stop making mortgagepayments only because they are underwater.3

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultFindingTwoFor borrowers who defaulted on their mortgage, default closely followed a negativeincome shock regardless of their income level or payment burden.Did the relationship between negative income shocks and mortgage default vary according to borrower income level or payment burden?To answer this question, we categorized our sample of homeowners who defaulted according to their income level and payment burden (asmeasured by their total DTI at origination) and then examined their monthly income and mortgage payments. Our data show that for thosewho defaulted on their mortgage, default closely followed a negative income shock irrespective of income level or total DTI at origination.In Figure 3, we illustrate the relationship between income loss and default for a sample of Chase mortgage customers who had a Chase depositaccount, defaulted on their mortgage, and for whom we can observe gross income at origination.8 Figure 3 is analogous to Figure 2, but in Figure3 we used verified gross income from the homeowner’s mortgage application to divide the sample into income quartiles. The income measurewe used for the event study is the same as the income measure used in Figures 1 and 2, and includes all checking account inflows. For all fourincome quartiles, the pattern is strikingly similar, indicating that regardless of income level, borrowers who defaulted did so after experiencinga steady drop in income in the months prior to default.Notably, even borrowers in the highest income quartile, where the average annual income at origination was over 110,000, may have defaultedas a result of an income drop.9 Furthermore, though higher income borrowers experienced smaller percentage income losses prior to default(as expected), there was no significant difference between the highest and lowest income quartiles in terms of the time span between whenincome started dropping and when borrowers started missing mortgage payments. For borrowers in both the highest income quartile and thelowest income quartile, the drop in mortgage payments made began one or two months after the drop in income despite the 86,000 per yeardifference in average income between the two sub-samples. Though income and wealth are generally correlated, the higher income householdsin this sample who defaulted on average did not have a suitable financial buffer to withstand the loss in income and delay default.Figure 3: Default followed a negative income shock for borrowers across the income distribution, suggesting that evenhigh income borrowers were susceptible to default following income volatility.4

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultNext, we analyzed monthly income and mortgage payments for asample of borrowers who defaulted and for whom we could observetotal DTI at origination. Total DTI, which includes monthly obligationson all debts (mortgage, auto loan, student loan, credit card, etc.) aswell as other commitments such as alimony and child support, hasbecome an important underwriting standard, as the ability-to-repayrule requires that a borrower’s total DTI not exceed 43 percent inorder to satisfy the Qualified Mortgage rule.10Figure 4 shows the relationship between income and mortgage defaultfor borrowers who satisfied the “ability-to-repay” rule (had a totalDTI at origination below 43 percent) in the left panel and borrowerswho did not (had a total DTI at origination above 43 percent) in theright panel.11 The income pattern that precedes default was similarfor borrowers in both groups, suggesting that it was a loss in incomerather than a high payment burden at origination that triggereddefault. If a high payment burden alone were enough to triggerdefault, we would expect to see much less of an income shock or noincome shock for those borrowers that had total DTI at originationabove 43 percent.The similarity in response for both sets of borrowers suggests thatunderwriting standards that rely on affordability targets based onsteady-state income measured at origination may not be the mosteffective method of reducing mortgage defaults. Ability-to-repaymeasures observed at origination cannot account for the futurevolatility of income or directly measure a household’s ability towithstand this volatility. Furthermore, our data do not support adistinction between “affordable” and “unaffordable” mortgagesbased on a 43 percent total DTI cutoff. It is important to note thatthe mortgages in our sample cover a wide range of vintages andmost were originated before the ability-to-repay requirement wasofficially implemented in 2014. Furthermore, for the vintages weexamined, the types of debt included in the total DTI calculation mayhave changed, further complicating any analysis of the relationshipbetween total DTI and default, including the analysis herein.12Ourdata do notsupport a distinctionbetween "affordable" and"unaffordable" mortgagesbased on a 43 percenttotal DTI at originationcutoff.Figure 4: Default followed a negative income shock for borrowers above and below the 43 percent total DTI at originationthreshold, suggesting that it was a drop in income rather than payment burden at origination that triggered default.5

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultFindingThreeRecovering from mortgage default was associated with recovering from a negativeincome shock; homeowners who experienced deeper and longer duration dropsin income became increasingly delinquent.In the previous findings, we presented evidence that default closelyfollowed a negative income shock for borrowers across the incomespectrum. We now turn to the question of what happened in themonths following default. How should we interpret the partial recoveryin income after default that is evident in Figure 1? For borrowers whodefaulted, was there a continued connection between their paths ofincome and their state of delinquency in the months that followeddefault? To answer these questions, we categorized homeownerswho defaulted according to their status in the month after theydefaulted (less delinquent, similarly delinquent, or more delinquent)and then observed the path of their incomes.13 We found that theincome of homeowners who became more delinquent exhibited largernegative shocks and recovered to a lesser extent than the incomes ofhomeowners who resumed making mortgage payments.The left panel of Figure 5 shows the change in the path of monthlyincome over the 12 months before and after default relative tobaseline (12 months before default) for borrowers who defaulted(defined as 90 days delinquent). The right panel of Figure 5shows the change in mortgage payment made for the same set ofborrowers. In each panel, borrowers are grouped according to theirdelinquency status in the month following default. That is, thereare separate lines for the income and mortgage payment made for(1) borrowers who became less delinquent in the next month bymaking a payment equivalent to at least twice their normal payment,(2) borrowers who made their scheduled payment in the followingmonth but did not make up any missed payments and thereforeremained similarly delinquent, and (3) borrowers who missed thenext mortgage payment and became more delinquent.14The pattern of monthly changes in income for the average borrowerwho fell further into delinquency in the next month shows both alarger negative income shock in the months before default (on average73 percent larger than the negative income shocks experienced bythe borrowers who stayed the same or recovered) and less incomerecovery in the months that followed default (on average about 600 per month less compared to those who recovered and 400per month less than those who stayed the same).These analyses further highlight the connection between negativeincome shocks and default: not only did default follow a negativeincome shock, recovering from default was also closely related to thelength and depth of the income shock. In other words, homeownerswho suffered a temporary negative income shock missed a fewpayments but then were able to resume making payments as theirincome recovered. In contrast, homeowners who experienced adeeper and more permanent negative income shock were unable tomake mortgage payments and fell further into delinquency.Figure 5: Following an initial 90 day delinquency, homeowners who experienced larger negative income shocks and lessincome recovery became more delinquent.6

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultFigure 6 is similar to Figure 5, but in this instance we began with borrowers who were 30 days delinquent and then categorized themaccording to their maximum delinquency observed over the next 12 months to illustrate the relationship between income loss and delinquencyseverity.15 Borrowers in the current category, who made two payments in the next month and then did not miss a payment in the next 12months, exhibited a complete income recovery. In contrast, borrowers who fell further delinquent or into foreclosure showed larger andlonger duration losses in income. We conclude from the evidence in Figures 5 and 6 that recovery from delinquency was closely tied toincome recovery—the degree and speed of homeowner recovery from default varied with the degree and speed of their income recovery.16Figure 6: Following an initial 30 day delinquency, homeowners who experienced larger negative income shocks and lessincome recovery had higher maximum delinquency in the following year.7

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultFindingFourHomeowners with larger financial buffers used their savings to delay mortgagedefault following a negative income shock.In the previous findings we presented evidence that mortgage default closely followed an income shock and that the extent to whichborrowers recovered from default was closely tied to the extent to which their income recovered. What might help borrowers delaydefault? Intuition suggests that having savings might help delay default after an income shock, so we turn to an examination of the roleof financial buffers.We begin with a sample of de-identified Chase customers with a deposit account who defaulted on their mortgage and then split thissample by above-median and below-median deposit account balance.17 We measure deposit account balances as the sum of checkingand savings account balances and will use the term “financial buffer” to refer to this measure.Figure 7 shows the change in the path of monthly income, mortgage payment made, and deposit account balance over the 12 monthsbefore and after default relative to baseline (12 months before default) for homeowners in the below-median (less than 794) depositaccount balance group in the left panel and above-median (greater than 794) deposit account balance group in the right panel. Thebaseline deposit account balance is the average over the 6-month period 18 to 13 months prior to default.The average borrower in the sub-sample with a below-median deposit account balance (left panel of Figure 7) had a monthly mortgagepayment of about 780 and an average daily balance of about 400 in their deposit accounts at baseline, which means they were holdingless than one mortgage payment equivalent in reserve.18 For this sub-sample, the drop in mortgage payment made coincided withtheir drop in income. On average, these borrowers had little in reserves, and therefore a negative income shock led directly to reducedmortgage payments in the very same month. Three months after income first dropped, these borrowers entered default (defined as 90day delinquency).In contrast, the average borrower in the above-median deposit account balance sub-sample (right panel of Figure 7) had a financialbuffer of 2.2 months of mortgage payment equivalents. The average monthly mortgage payment for this group was about 1,000 andthe average daily balance in their deposit accounts was about 2,200 at baseline. The amount of time between the initial negative incomeshock and the first drop in mortgage payment made in the right panel of Figure 7 is notably different than in the left panel. Homeownersin the right panel experienced a negative income shock (- 350) of a similar magnitude to homeowners in the left panel (- 330). However,the borrowers with above-median deposit account balances did not default until eight months later. Instead, they used the cash in theirdeposit account (their financial buffer) to continue making mortgage payments and delay default, and their deposit account balancedeclined accordingly as the negative income shock hit. Because this sample is composed of homeowners with a mortgage who defaulted,the eventual default is by construction. However, the above-median deposit account balance gave this group an opportunity to withstandthe initial negative income shock without reducing their mortgage payment. This implies that having a financial buffer may help borrowersprevent default altogether when experiencing income shocks that are temporary in nature.8

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultFigure 7: When faced with a negative income shock, borrowers with a smaller financial buffer reduced their mortgagepayments coincident with the drop in income; borrowers with a larger financial buffer used their savings to continuemaking mortgage payments and delay default.Figure 7 provides evidence that borrowers with a larger financial buffer were able to delay default after an income drop by drawing on theirsavings. Figure 3 provides evidence that for those who defaulted, default followed closely after an income shock for borrowers across theincome distribution, suggesting that even high income borrowers are susceptible to income shocks. Next, to bring these ideas together, weanalyzed default rates by income, payment burden, and financial buffer levels to see which was more important in determining default.9

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultFindingFiveDefault rates for homeowners with small financial buffers were higher regardlessof income level or payment burden. Therefore, building and maintaining a financialbuffer may be a more effective tool to help borrowers avoid default than meetingtotal DTI standards at origination.What was the relationship between default rates, income, payment burden, and financial buffers? To answer this question, we expanded oursample to include all mortgage customers who had a deposit account with Chase (no longer requiring default). We found that homeownerswith a small financial buffer were more likely to default regardless of their income level or payment burden.We first examined default rates by income level and size of financial buffer using a sub-sample of mortgage customers for whom we couldobserve verified income at origination and who had a deposit account balance with Chase in January 2013. We dropped homeowners whodefaulted (defined as being 90 or more days past due) during 2013 to introduce a 12 month gap between our observation of deposit accountbalance and delinquency status to mitigate the risk that we are observing deposit account balances just after a draw down due to a negativeincome shock but just prior to default.19 We normalized deposit account balance by dividing by the homeowner’s average scheduled mortgagepayment and use this “number of mortgage payment equivalents held in reserve” to quantify their financial buffer.20In Figure 8, we show the one-year default rate (default is defined as being 90 or more days past due in any month of 2014) for thissample against the number of equivalent mortgage payments held in reserve for the full sample and then separately for borrowers withabove- and below-median income at origination. The histogram in the right panel displays the number of above- and below-median incomehomeowners in each financial buffer bin.21Figure 8: Default rates were higher for borrowers with lower levels of financial reserves regardless of income level,suggesting that default was likely determined more by the size of the borrower’s financial buffer and less by their income.As one might expect, borrowers that held more mortgage payments equivalents in reserve had lower default rates. For the full sample(and both sub samples) default rates decreased as the number of mortgage payment equivalents held in reserve increased. For thefull sample, the one-year default rate for homeowners who had less than one mortgage payment held in reserve was 2.54 percent. Incontrast, the one-year default rate for homeowners who had the equivalent of four or more mortgage payments held in reserve was0.36 percent. Thus the default rate for borrowers with little in savings was seven times higher than the default rate for borrowers withat least four mortgage payment equivalents held in reserve.10

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultThis result suggests that providing homeowners with an incentive to hold a financialbuffer of several mortgage payment equivalents could be a useful measure aimedat preventing default. Furthermore, because almost half of homeowners had littleThe default rateto no financial buffer (54 percent of this sample had fewer than four mortgageforborrowerswith littlepayment equivalents held in reserve) and these homeowners have much highersavings was seven times higherdefault rates (84 percent of total defaults are from homeowners with fewerthan the default rate for borrowersthan four mortgage payment equivalents held in reserve), incenting thesehomeowners to build a larger but still modest financial buffer could preventwith at least four mortgage paymenta large number of defaults. The marginal impact of each additional mortgageequivalents held in reserve, and 84payment held in reserve beyond four or five was small, which suggests thatpercent of total defaults were fromonly a relatively modest amount of savings could have a substantial impact onhomeowners with fewer than fourdefault rates. In other words, the returns to incenting homeowners with verymortgage payment equivalentslittle in reserve to save more could be very large.held in reserves.A comparison of default rates for the above- and below-median income sub-samplesshown in Figure 8 indicates that, for borrowers with less than one mortgage paymentequivalent held in reserve, the default rate for the below-median income sample was 1.5percentage points higher than the default rate for the above-median income sample. However,for borrowers with at least one mortgage payment equivalent held in reserve, the difference in default ratesbetween the two sub-samples was considerably narrower (0.4 percentage points). This is particularly notable given the nearly 80,000income gap between the average above-median income borrower and the average below-median income borrower. The fact that defaultrates were similar for borrowers with more than one mortgage payment in reserve suggests that the lack of a financial buffer might havebeen a more important determinant of mortgage default than income level.An additional observation from Figure 8: within each income group, there was substantial variation in financial buffer size. In fact, thehistogram in the right panel shows that the proportion of borrowers in each bin was not that different across income groups, implying thatthe correlation between income and savings was fairly weak. While one might have expected that higher income borrowers would makeup a larger proportion of observations as financial buffer increased, that was not evident in our data. 22As noted above, the data in Figure 8 suggest that it was the variation in financial buffers across borrowers within each income groupthat determined default rate more so than the income level of a borrower—for the below-median income borrowers with less than onemortgage payment in reserve, increasing their deposit account balance by the equivalent of one mortgage payment (moving along the lineto the right) had a greater impact on reducing the likelihood of default than increasing their income and moving into the above-medianincome group (moving to the lower line). The average borrower in the below-median income group earned 42,000 per year. Practicallyspeaking, they would likely find it more feasible to save a few mortgage payments over time than to move to the above-median incomegroup (average income of 122,000 per year).11

JPMorgan Chase InstituteFalling Behind: Bank Data on the Role of Income and Savings in Mortgage DefaultNext we investigated a commonly used metric of affordability in the mortgage underwriting process—total DTI at origination—and examinedhow mortgage default rates varied for borrowers with different levels of total DTI at origination and financial buffers. Again, we began witha sample of mortgage customers who had a deposit account with Chase and then subset this sample to those for whom we could observetotal DTI at origination. We found that homeowners with smaller balances in their deposit accounts were more likely to default regardlessof their total DTI at origination.Figure 9 shows the one-year default rate for homeowners with various levels of financial buffers. Again, the size of the homeowner’sfinancial buffer is expressed as the number of mortgage payment equivalents held in reserve in January 2013. Default rates are shownseparately for borrowers who had a total DTI at origination above 43 percent and borrowers who had a total DTI at origination below 43percent. 23 The histogram in the right panel displays the number of homeowners in each financial buffer bin, split according to total DTI.Figure 9: Default rates were higher for borrowers with lower levels of financial reserves regardless of total DTI,suggesting that default was likely determined more by the size of the borrower’s financial buffer and less by their totalDTI at origination.Again, borrowers who held more mortgage payment equivalents in reserve had lower default rates—for both sets of borrowers defaultrates decreased as the number of mortgage payment equivalents held in reserve increased. Importantly, the overall shape of the functionthat relates default rate to financial buffer was the same regardless of whether the household was above or below 43 percent total DTI atorigination. Similar to what we observed for income, it is true that default rates are higher for those with higher total DTI at origination.However, for borrowers in the above 43 percent total DTI sub-sample with less than one mortgage payment in reserve, increasing theirdeposit account balance by the equivalent of one mortgage payment (moving along the line to the right) had a greater impact on reducinglikelihood of default relative to moving into the below 43 percent total DTI sub-sample (moving to the line below). This findin

mortgage, default was correlated with a drop in income. This is illustrated in Figure 1, which is reproduced from Mortgage Modifications after the Great Recession and shows the relationship between income loss and default for a sample of de-identified Chase mortgage customers who had a Chase deposit account and defaulted on their mortgage. 1, 2

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